Italy on Wednesday became the first major economy to require an international
bail-out as its debts hit “totally unsustainable levels”.

The country's escalating crisis prompted questions about whether European leaders had sufficient will or financial firepower to rescue it.

The interest rate at which the Italian government borrows on the international bond markets hit seven per cent – the point at which the smaller eurozone economies of Ireland, Portugal and Greece had to be rescued.

Italy, the world’s eighth largest economy, has more than £1.5 trillion worth of debt, which has prompted speculation from some world leaders that it is too big to rescue.

Silvio Berlusconi’s pledge to resign as prime minister failed to stem the financial turmoil, and mixed messages on how the eurozone would respond to the crisis added to uncertainty in the markets.

Angela Merkel, the German chancellor, called for deeper European integration and a new “breakthrough” treaty that would give the EU greater fiscal powers to stop member states from slipping into dangerous levels of debt.

However, there were also reports that German and French officials were privately looking at ways to make it possible for European nations to leave the eurozone, causing US shares to slump by three per cent last night.

The turmoil dramatically increased the risk of a “double dip” recession in Britain, with most economists predicting that the economy will grind to a halt before the end of the year.

Senior Government sources believed that a full-scale Italian financial collapse could knock “several percentage points” off the size of the British economy. British banks have more than £42 billion of outstanding loans to Italy, including almost £10 billion to the government.

David Cameron described the state of the Italian economy as “tragic” and urged European leaders to intervene quickly in the situation to stop the crisis spreading to Spain and France. “If you don’t have credibility about your plans to deal with your debts and deal with your deficits, whether you like the markets or not, they won’t lend you any money,” he said.

“That’s what we are seeing in countries like Greece, and now tragically Italy, where the price of borrowing money is getting to a totally unsustainable level.

“It’s a lesson for all of us to have sustainable plans to get on top of our debt and our deficits. In terms of Europe, the problems of contagion, is that as we agree a decisive write-down of Greek debt, people inevitably start asking questions about other countries.” He urged European leaders to “urgently” finalise the plans over how a one-trillion euro fund to rescue beleaguered countries would be funded and operated.

“You need to have in place the biggest possible firewall”, he said. “That is what the EFSF [European Financial Stability Facility] is all about and the eurozone urgently needs to put flesh on the bones on the size of that firewall to stop this contagion going any further.”

The Italian president, Giorgio Napolitano, announced that austerity plans would be agreed “within days”, paving the way for Mr Berlusconi’s departure and a new government to be installed next week.

The Italian crisis move into a critical phase after the EU formally warned the Italian government that its plans to cut public spending did not go far enough. A “monitoring mission” from the EU and the International Monetary Fund arrived in Rome to begin scrutinising Italian accounts.

On Tuesday, Mr Berlusconi failed to win an outright majority in the Italian Parliament over his spending plans and announced his imminent resignation.

Mr Napolitano said: “Italy must regain credibility and confidence as a country for us first of all to get out from a very dangerous squeeze on financial markets.”

He added that a new government could be formed quickly and insisted there was not a risk of “prolonged political instability”.

Stock markets around the world fell sharply, with the FTSE-100 index closing down almost two per cent at 5,460. Bank shares fell by more than five per cent. The French and German markets were down by more than two per cent.

Jennifer McKeown, a senior European economist at Capital Economics, said: “It is a panic. Rome is burning. Governments need to stop the fire spreading. Britain can’t escape the implications of this crisis.” Marc Ostwald, an economic strategist at Monument Securities, added: “This is a form of meltdown. I would imagine the telephones between international finance ministries and central banks are in danger of running so hot they’ll melt down themselves.”

Eurozone leaders were accused of failing to get on top of the crisis. Last month, they announced plans for a one-trillion-euro bail-out fund but have struggled to raise money for the scheme.

Alistair Darling, the former chancellor, said: “I despair of the way in which EU leaders are constantly behind events. I do not think enough people realise how serious this crisis is, and how hard it is going to hit us. This is far worse than the banking crisis of 2008.”

Wolfgang Schaeuble, the German finance minister, said that Italy should apply for European help if necessary. However, he insisted he was not currently concerned about the cost of Italian debts because the interest rates would fall once a new prime minister was installed.

The French finance minister described the situation as “uncertain and tempestuous”. Several other European leaders expressed concern over the potential size of an Italian bail-out, which would dwarf deals agreed for other countries such as Greece and Ireland.

“It’s hard to see that Europe would have the resources to take a country the size of Italy into the bail-out programme,” said Jyrki Katainen, the Finnish prime minister.

The Italian crisis overshadowed the ongoing turmoil in Greece, where George Papandreou announced his resignation as prime minister. A new national unity government will be appointed on Thursday. The outgoing prime minister said the country would do everything it could to stay a member of the euro.

The EU has asked for a written guarantee that Greek austerity plans will be implemented as promised.

There were signs of increasing nervousness on the financial markets over the Spanish and French public finances. Investors are waiting for the Spanish election later this month and the new government will have to announce spending cuts quickly to avoid the crisis spreading to the country. The cost of French debts rose to a record margin compared with those of Germany.